Message from TraderJanie
Humans rely on rules of thumb; some work, but many are story-based and do not stand up to scrutiny, in other words, can’t be proven with empirical evidence. For example. one of the most firmly held beliefs in the trading world, and has been drummed into our noggins for years is, a stop loss is the preeminent method for averting risk yet, for equities, research has shown fixed stops losses hurt performance and in many cases completely remove any edge a set of rules may have over dart throwing.
Ya I know, it feels good when a stock keeps moving lower and lower (or higher and higher when short) and a stop takes you out. On the other side, the research, which is backed by up by two decades of test results on many short‐term trading strategies, suggests that stops get hit often and accumulate many, many losses. Few trading strategies can overcome these aggregated losses.
Larry Connors and Stop Losses
Larry Connors conducted tests with different levels of stops. He tried 5%, 7.5% and 10% maximum loss stops. After he ran the tests he noticed that higher stops had better results. He then got curious and tested larger and larger stops all the way to a 50% stop, a level that, in essence, is not a stop. A general pattern emerged that the larger the stop the better the results.
For many traders, stops are a must. Psychologically it allows them to take trades, especially difficult trades but on the whole, the edges you see in strategies are lower when stops are applied to them.
And don’t get me started on how the exchanges screw with your stops.
So then how do you get out of a trade if you don’t use a stop loss?
QiT uses something called a Dynamic Exit. We don’t set the stop loss at a set percentage or a set number of days but rather when a particular indicator reaches an exit point. This could be as simple as an exit when the 5-day moving average crosses a 15-day MA, when the MACD crosses down (or up), etc. or when the 2-day RSI hits a predetermined level. Here at QiT, we use the Connors RSI.
Different exits will give widely different test results so the ability to backtest your exit to see which is the most beneficial is a huge advantage over paper-trading your exit strategy over time and “testing” different exit types. Another reason algorithms are superior to discretionary trading.
Another story is that Buy and Hold is “safer” than swing trading.
In order to examine the reasons behind this idea, you’ll need to look at the widely used Ibbotson Associates historical data, which “proves” that stocks have generated greater returns than bonds (which in turn have generated higher returns than cash). Many have fallen for the premise and rationalization behind this data. Unfortunately, even experienced professionals accept these assertions without giving the idea any further thought.
The problem is the “100% invested 100% of the time” mindset is to assume that in the midst of a maximum drawdown one will have the intestinal fortitude to not abandon a strategy and simply stay the course. An achievement the majority of investors could not possibly attain. It can be extremely difficult for most investors to maintain an out-of-favor strategy for six months, let alone for many years.
Going back to 1990 when the Dow traded around 2,750, you’ll find this index reverts back to within 1% of it’s opening value at least once, in every given year, and sometimes three or four times as was the case in 2011. I don’t know about you but that would drive me to drink.
I’d be rich if I had a nickel for every time I heard, “If only I had bought Apple when it IPO.” Apple IPOd at $22.00 in 1980 and it hung around its IPO price until 1985. Of course, it has split many times since and is trading at $170.00 today and $5000 invested in 1980 would now be worth $1.2 million but who could have hung on to it that long? So yes you would be rich IF you had held on to AAPL since 1980. I have yet to meet a human being who has that kind discipline. Human psychology is not conducive to Buy and Hold.
And that was if you had the insight to buy AAPL and not one of the hundreds of stocks that have closed their doors since 1980.
Plan your trade and trade your plan